September 14, 2009
Post-Recession Policies Matter More than Theory
There’s a wonderful fight brewing between some of the world’s best known economists. The headline pugilists – Paul Krugman and Robert Lucas – are Nobel laureates. It is the kind of purely intellectual debate of which there is too little. It is also fun.
The fight measures up something like this. There are two dominant, and one peripheral explanation for why recessions happen. The first two share the same intellectual origins, crafted carefully over the past century. The peripheral explanation depends heavily on rules of thumb about how financial markets behave.
The dominant theories account for recessions in two ways: a real shock to the economy like a rapid rise in gas prices, or the inability of businesses to smoothly adjust prices to the right level. Both of these approaches more than partially explain the last recession. The gas price increase everyone remembers all too well, but it was the helplessness of homeowners to cut the price of their homes to a point they would sell that was central to the housing crisis.
One of these explanations (which Lucas favors) does not admit significant frictions between people and businesses in the conduct of trade. The other (favored by Krugman) bases its conclusions on numerous small frictions between people and business that in total prevent markets from operating smoothly. Both treat individuals and businesses as fairly similar beasts (rational within the narrow scope of gaining profits, yet imperfectly knowledgeable about the world).
Both of these models are effective at explaining other characteristics of the world’s economy, and share similar (but not identical) policy prescriptions. For the record, my doctoral dissertation and some later research focused on measuring these small frictions. That puts me squarely in the Krugman camp. The peripheral explanation argues that many recessions develop from the bursting of financial bubbles, which leave firms thirsting for access to their lifeblood of capital. The result is, in the quaint wording of J.M. Keynes, a ‘liquidity preference’ for holding cash that places a stranglehold on commerce. This explanation has an all too familiar ring to it. Krugman has become recently fond of some of these arguments and wants them incorporated into the dominant theories.
Having hastily summarized 75 years of significant writing into 300 odd words I probably need to offer an apology. But in the end it is not the theory, but rather the policies they spawn that matter to most of us.
The types of fiscal stimulus Congress passed earlier this year fell from favor not because of economic theory, but rather because they rarely work well. The role of the Federal Reserve became ascendant not because of crafty economic models, but because it was exceedingly successful. Two years hence, the Fed will be working its magic and economists will be arguing over the effect of the stimulus (which I supported at a much more modest level). I don’t know how the debate will end, but one thing is for sure, we’ll still be paying for the stimulus when the argument is over.
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